Rev. Rul. 84-138

ISSUES

For purposes of determining whether a corporation will continue to qualify as a regulated investment company under section 851 of the Internal Revenue Code, (1) are certain reimbursements included in the taxpayer's gross income under section 61(a) and, therefore, subject to the gross income requirement of section 851(b)(2); and (2) in applying the 50 percent diversification test of section 851(b)(4)(A) regarding the value of total assets, must this test be applied with respect to each entity that purports to be a regulated investment company or may it be applied on a combined basis at the parent level when both the parent corporation and its wholly owned subsidiary purport to be regulated investment companies?

FACTS

The taxpayer is a non-diversified, closed-out, management investment company registered under the Investment Company Act of 1940. The taxpayer elected to be taxed as a regulated investment company under subchapter M (sections 851-855) of the Code. In 1981, the taxpayer established S, a wholly owned subsidiary, to operate as a small business investment company under the Small Business Act of 1958. S also elected to be taxed as a regulated investment company under subchapter M.

Because the taxpayer and S use the same facilities and some of the same personnel, it was agreed that the taxpayer would pay all the expenses for general and administrative overhead, including personnel costs. S agreed to reimburse the taxpayer for its pro rata share of these expenses on an arms length basis. During its 1981 tax year, the taxpayer received reimbursements from S. The taxpayer was not engaged in the business of receiving compensation for services of the type that were reimbursed. The reimbursements were not included in gross income and no deduction was taken by the taxpayer for S's share of the expenses. If the reimbursements were included in the taxpayer's gross income, they would represent 20 percent of the taxpayer's gross income for its 1981 tax year.

LAW AND ANALYSIS

Section 851(b)(2) of the Code provides that a corporation shall not be considered a regulated investment company for any taxable year unless at least 90 percent of its gross income is derived from dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock or securities.

Section 851(b)(4)(A) of the Code provides that a corporation shall not be considered a regulated investment company for any taxable year unless at the close of each quarter of the taxable year at least 50 percent of the value of the corporation's total assets is represented by (i) cash and cash items (including receivables), Government securities and securities of other regulated investment companies, and (ii) other securities for purposes of this calculation limited, except and to the extent provided in section 851(e), in respect of any one issuer to an amount not greater in value than 5 percent of the value of the total assets of the taxpayer and to not more than 10 percent of the outstanding voting securities of such issuer.

Section 851(b)(4)(B) of the Code requires that at the close of each quarter of the taxable year not more than 25 percent of the value of the regulated investment company's total assets be invested in the securities (other than Government securities or the securities of other regulated investment companies) of any one issuer, or of two or more issuers that the taxpayer controls and that are determined, under regulations prescribed by the Secretary or his or her delegate, to be engaged in the same or similar trades or businesses or related trade or businesses.

Section 1.851-2(c)(1) of the Income Tax Regulations states that when at least 50 percent of the value of the total assets of the corporation satisfies the requirements specified in section 1.851-2(c)(1), and when the limiting provisions of section 851(b)(4)(B) of the Code and section 1.851-2(c)(2) are not violated, the corporation will satisfy the requirements of section 851(b)(4), notwithstanding that the remaining assets do not satisfy the diversification requirements of section 851(b)(4)(A). For example, a corporation may own all the stock of another corporation, provided it otherwise meets the requirements of section 851(b)(4)(A) and (B).

In Rev. Rul. 78-388, 1978-2 C.B. 110, an accrual method taxpayer incurred moving expenses and sustained losses due to abandonment of leasehold improvements in moving from property acquired by the state. The taxpayer's request for a relocation payment under the Uniform Relocation Assistance and Real Property Acquisition Policies Act of 1970, 42 U.S.C. sections 4601-4655 (1976), was approved by the responsible government agencies during the taxable year of the move and payment was received in a subsequent year. Although the actual payment was not received until the next year, the taxpayer had, before the expenses and loss were incurred, written authorization to incur the expenses up to the amount by the agency. The moving expenses and abandonment losses were held not to be deductible to the extent they were reimbursable.

In Rev. Rul. 79-263, 1979-2 C.B. 82, a cash method cattle farmer received authorization under the Federal Disaster Assistance Administration's Emergency Livestock Feed Assistance Program for partial reimbursement of the anticipated cost of replacing feed destroyed as a result of a drought and was reimbursed for the feed expenditures the year after they were made. Rev. Rul. 79-263 holds that only the portion of the expenditures for which reimbursement is not available is deductible under section 162 of the Code and the reimbursement payments are not includible in the taxpayer's gross income.

Rev. Rul. 80-348, 1980-2 C.B. 31, holds that amounts paid by an international labor union to reimburse delegates from local chapters for expenses of traveling away from home to attend the annual convention are not includible in gross income, and no deduction is allowable for the reimbursed expenses under section 162 of the Code, if the delegates have a right or expectation of reimbursement, even though the reimbursement is received in a later year.

In Jergens Co. v. Commissioner, 40 B.T.A. 868 (1939), certain cost-sharing reimbursements were held to be includible in the recipient's gross income because the recipient was in the business of rendering the type of services which were reimbursed by a related corporation. The taxpayer in the present situation is not engaged in the business of receiving compensation for services of the type that were reimbursed. Therefore, the taxpayer's situation is distinguishable from Jergens.

In Glendinning, McLeish & Co., Inc. V. Commissioner, 24 B.T.A. 518 (1931), aff'd, 61 F.2d 950 (2d Cir. 1932), XII-1 C.B. 279, the Board of Tax Appeals stated that, where a taxpayer makes expenditures under an agreement that the taxpayer will be reimbursed therefor, such expenditures are in the nature of loans or advancements and are not deductible as business expenses.

In General Management Corp. v. Commissioner, 46 B.T.A. 738 (1942), aff'd on other grounds, 135 F.2d 882 (7th Cir. 1943), cert. denied, 320 U.S. 757 (1943), the Board of Tax Appeals stated that mere advancements partake of the nature of loans and amounts received in reimbursement therefore are not includible in gross income.

In the present situation, the taxpayer received amounts as reimbursement for paying S's general and administrative overhead expenses, including personnel costs. The amounts paid by the taxpayer for these expenses represented advancements made on behalf of S. According to the decision in General Management Corp., and Rev. Rul. 80-348, the amounts received in reimbursement for advances are not includible in gross income. Because these amounts are not gross income, they are excluded from the application of section 851(b)(2) of the Code.

Section 851(b)(40(A) of the Code requires that a regulated investment company meet the diversification test contained in this provision at the close of each quarter of the taxable year. Both the taxpayer and S are regulated investment companies that are part of a parent-subsidiary relationship. Neither section 851(b)(4)(A) nor the regulations thereunder allow the diversification test to be applied at the parent level to the combined assets of the parent and its wholly-owned subsidiary.

HOLDINGS

(1) The reimbursements from a subsidiary are not included in the taxpayer's gross income under section 61(a) of the Code and, therefore, are not subject to the gross income requirement of section 851(b)(2).

(2) The 50 percent diversification test of section 851(b)(4)(A) of the Code regarding the value of total assets is applied with respect to each entity that is a regulated investment company and may not be applied at the parent level on a combined asset basis.